More Firms Using Non-Traditional Measures to Determine Executive Compensation

What gets measured, gets managed, has long been a by-word of effective organizational oversight.

The problem faced by executives in all sectors is whether the measures provided by traditional GAAP or international accounting conventions actually capture information relevant to the operations of a contemporary institution. Of even greater concern is whether the performance of those charged with running these enterprises can be fairly judged by the available - and approved - metrics.

For twenty years, or since the early twinklings of the dotcom era, managers, their staffs, their boards, lenders, investors and customers have worried about the disconnect between conventional accounting methods and the globalized, technologically-driven economy.

Opposition to change has come from all sides because of the fear that one's own company, industry, nation will be disadvantaged - and financially penalized - by changes that might affect through expensing or capitalizing elements of the enterprise's strategy execution. Though numerous studies have been conducted and literally dozens of solutions proposed, none have been formally adopted for fear of creating some sort of economic imbalance.

The result has been that companies have attempted on their own to identify, measure, manage and then report those aspects of their operational conduct that appear to be most significant. Given the rise in importance of intangible factors like brand or innovation and relative decline in importance of older, tangible measures related to industrial production or real estate value, this only makes sense, especially if the data are acquired and reported in a rigorous manner.

The problem has come, as the following article explains, when selective reporting of metrics chosen to highlight only advantageous performance affects compensation formulae. That sort of manipulation raises concerns about the efficacy of the entire system and reinforces the arguments of those who believe that stronger regulatory oversight is required.

The reality is that some sort of supra-national and industry system must be agreed upon for there to be any useful comparative data generated and, therefore, any possibility of management against global norms. That goal, alas, seems further away than ever. In the interim, however, the use of non-traditional metrics should be encouraged. As a learning device and as a source of innovation more closely related to the world as it is developing, this may - with sufficient transparency - provide a practical guide for how to effectively manage and appropriately reward the institutions and people on whom the global economy depends. JL

Michael Rapoport reports in the Wall Street Journal:

U.S. companies increasingly are using unconventional earnings measures in determining bonuses, making it easier for them to appear more profitable when they reward executives with big paydays.

Last year, 542 companies said they determine compensation using financial measurements that differ from U.S. accounting standards, according to an analysis performed by consultant Audit Analytics for The Wall Street Journal. That is more than double the 249 companies that did so in 2009. The practice can be controversial because it strips out various costs—from employee stock payments to asset write-downs—that can depress profits.

Such moves are on the rise at a time when the Securities and Exchange Commission has said it is scrutinizing nonstandard earnings measures. The commission declined to comment on their use in executive-pay decisions.

"Everything you can think of to manipulate this has been done," said Gary Hewitt, head of research at GMI Ratings, a corporate-governance research firm.

U.S. companies report quarterly results based on generally accepted accounting principles, or GAAP, but regulators also allow them to provide non-GAAP adjusted measures as long as they provide proper disclosure. Some companies use the non-GAAP measures as the basis for the profit targets they must hit to award incentive bonuses to executives.

Companies are allowed to use nonstandard measures in setting executive pay, and some observers said they better represent a company's health and its executives' performances by excluding items the companies don't see as relevant to their core operations. Others disagree.

"We're very frustrated with that," said Michael Pryce-Jones, a senior governance analyst at CtW Investment Group, which works with union pension funds on shareholder initiatives. When companies use such customized measures, he said, investors "are being given the upside, but they're not being given the downside."

For its analysis, Audit Analytics examined public firms with $700 million or more in stock not under the company's control. The results showed the use of nonstandard measures for executive pay has risen steadily each year since 2009. The 542 companies represent 28% of the 1,957 firms examined by Audit Analytics for 2013.

One example cited by some corporate-governance advocates: medical-products distributor McKesson Corp., which awarded Chief Executive John Hammergren $51.7 million in compensation for fiscal 2013.

To help determine the $3.7 million he received in short-term incentive pay, McKesson used a measure of its earnings it adjusted not once but twice. It took the nonstandard earnings measures it disclosed to investors in its earnings reports, which already had stripped out a variety of expenses, to boost the year's earnings by 74 cents a share, to $6.33, and then stripped out more costs to increase earnings an additional 88 cents, to $7.21.

Activist shareholders have complained about McKesson's pay structure, including its use of handpicked metrics. Shareholders voted "no" by more than a 3-to-1 margin last year on a nonbinding resolution to approve the company's executive-compensation package.

"This is something we're absolutely focusing on, looking at adjustments being made in bonus plans," said Mr. Pryce-Jones of CtW Investment Group, which was active in the campaign against McKesson.

McKesson said its board "exercises great discipline" in deciding on pay, and its modifications are representative of its recurring performance and match how Wall Street views its profits.

Some others think the non-GAAP use is justified. "I really don't see the sort of blatant attempt to jigger the numbers so that someone gets more compensation than they're entitled to," said Charles Vaughn, a lawyer at Nelson Mullins Riley & Scarborough LLP in Atlanta who advises boards on compensation.

But other observers think some companies exclude some expenses from nonstandard measures that really shouldn't be excluded, like stock compensation, which they contend is a legitimate cost.

Business-software maker Salesforce.com Inc CRM in Your Value Your Change Short position posted a $110.7 million operating loss in fiscal 2013 under standard accounting rules, but it stripped out $379.4 million in stock-compensation expense to help it get to a $379.8 million operating profit that the company's board used for incentive-pay purposes.

Salesforce awarded CEO Marc Benioff $1.3 million in cash incentive pay as part of a $22.1 million pay package. The company declined to comment on its pay practices.

The concerns over nonstandard accounting measures are reinvigorating a debate that raged during the tail end of the 1990s stock boom. Back then, Internet companies often presented different sets of numbers such as "core earnings" or "operating earnings excluding special items" that purportedly offered investors a truer picture of their growth potential, even as the companies racked up substantial losses under traditional accounting measures.

After the market's 2000 crash and the corporate accounting scandals over the following few years cast a negative light on such practices, the SEC stepped in and required companies to disclose more about their nonstandard metrics. But the use of the metrics in quarterly earnings reports has continued, and now their use in executive compensation is becoming more prevalent as well.

"It's a dominant practice," said Renny Ponvert, chief executive and director of research at Management CV, which provides research on corporate executives.

The SEC has questioned some companies' use of nonstandard measures in pay decisions. Last year, the SEC asked building-products maker Trex Co. TREX in Your Value Your Change Short position to justify its exclusion from its pay metric of a big 2012 increase in its reserve for defective-products claims. The move boosted pretax income nearly sevenfold, and Trex CEO Ronald W. Kaplan was awarded incentive pay of more than $1 million in part based on that number, contributing to his total compensation of $3.7 million.

Trex said its current management joined the company after the problems leading to the reserve increase, and that it was "necessary" and "fair" to exclude it from bonus determinations.

Some observers said goodwill write-downs shouldn't be stripped out. Goodwill is the intangible asset a company carries to account for the excess of what it paid for an acquisition over the net value of the acquiree's hard assets. Many observers regard goodwill write-downs as acknowledgment that the company overpaid, and so they shouldn't be excluded from a measure used to evaluate management's performance.

Medical-device maker Boston Scientific Corp. BSX in Your Value Your Change Short position had goodwill write-downs in five of the last six years, but granted incentive pay to its CEO each year. The company had a $4.1 billion 2012 loss under standard accounting measures, but after excluding a $4.4 billion goodwill write-down and other charges, it had a $933 million profit used to set short-term incentive pay.

Citing confidentiality, a spokeswoman said the company doesn't comment on specifics about executive performance beyond its filings.